Crypto is big business. The world’s top 250 cryptocurrencies have a combined market cap of about $1.5 trillion and transact more than 1 million times a day.
Decentralised finance applications (“DeFis”) are emerging as a way of utilising crypto and blockchain technology for the facilitation of peer-to-peer transactions and are set to disrupt traditional banking services in a major way. With a current market cap of about $75 billion and forecasted growth in the trillions, it is possible that the DeFi space will challenge traditional financing transactions or, traditional finance may adopt (and adapt) the core technologies underlying DeFis.
What are DeFis?
Broadly speaking, DeFis are finance applications that operate without a centralised authority. In essence, a user is able to undertake a direct transaction that is verified on a blockchain without the involvement of a financial intermediary. At their core, DeFis are made up of a series of smart contracts that set the parameters and terms of the application, where programmable, self-executing code is used to automatically process and manage the various transactions that occur on the platform.
This article is focused on decentralised lending platforms (“DLPs”). DLPs are one of the more common forms of DeFis. DLPs typically involve software protocols operating on a public blockchain. Those protocols enable users to contribute cryptocurrencies in order to participate in lending pools providing collateralised loans and earning yield through interest and principal repayments by other users who borrow from those pools. To minimise risks for lenders and borrowers and as a way of managing price volatility and speculation, DLPs often involve “stable coins”, which are a type of cryptocurrency pegged to a reserve asset.
DeFis have attracted the attention of the Australian Securities and Investments Commission (“ASIC”). On 30 March 2021, ASIC released an updated version of information sheet, Initial coin offerings and crypto-assets (INFO 225) to offer some regulatory guidance to entities dealing in crypto assets (such as cryptocurrency, tokens or stable coins) or purporting to raise capital through an initial coin offering (“ICO”). An issue addressed in the paper was whether an ICO could be a managed investment scheme (“MIS”) under section 9 of the Corporations Act 2001 (“the Act”).
Generally, the definition of an MIS has captured schemes concerning more traditional financial products (such as property, equities and cash management trusts) where investors acquire an interest from a professional manager who manages a fund to produce a financial return. That said, the definition of MIS under the Act is intentionally broad and could certainly extend to various forms of DLPs. A particular DLP will be classified as an MIS if it is a scheme that has the following features:
- people contribute money or money’s worth as consideration to acquire rights (interests) to benefits produced by the scheme (whether the rights are actual, prospective or contingent and whether they are enforceable or not);
- any of the contributions are to be pooled, or used in a common enterprise, to produce financial benefits, or benefits consisting of rights or interests in property, for the people (the members) who hold interests in the scheme (whether as contributors to the scheme or as people who have acquired interests from holders); and
- the members do not have day-to-day control over the operation of the scheme (whether or not they have the right to be consulted or to give directions).
A “scheme” has been interpreted broadly to include any application that is capable of being identified within certain boundaries and is coupled with a series of steps or course of conduct to effectuate its purpose and pursue a clear program or plan. On its face, most DLPs could be caught by this definition.
There can be little doubt that if a DLP deals in commonly traded and widely dispersed cryptos like Bitcoin and Ethereum it could satisfy the “contribution of money or money’s worth”. If a DLP deals in a more complex form of crypto or stable coin this might become less clear. In this case, ASIC and the courts will most likely take a practical approach to determine whether a particular crypto falls within the scope of money or money’s worth and may consider a number of factors including:
- how the asset is valued and whether it is capable of being valued in money terms;
- how the asset is converted and whether it is capable of being converted into money; and
- whether the asset is used like money for the purposes of the platform.
“Contributions are to be pooled” has been interpreted broadly to include any aggregation of contributions that are subject to a common control or liability. If a DPL consists of pools that are managed and operated by a single entity it is likely that it could be caught by this concept. However, if a DLP consists of multiple, separately managed and operated pools, it could be captured by the broader concept of a “common enterprise”. Here, ASIC and the courts will need to determine whether the pools are closely connected operations maintained for the common purpose of deriving benefits for the pools. This may involve a consideration of a number of factors including:
- where the crypto assets are pooled;
- what purpose the crypto assets are being pooled for;
- whether any person or entity has management or control over the crypto assets once pooled; and
- how the crypto assets, once pooled, generate benefits for the users,
but may not involve a consideration of certain factors including:
- whether the pools are managed by different persons or entities;
- whether the pools derive separate profits; and
- whether the profits are shared between the pools.
If there is a scheme and it is established that contributions are to be pooled or used in a common enterprise, the last element of the MIS test is whether the users of the DLP have “day-to-day control over the operation” of the platform. This limb requires users as a whole to be able to participate in making the routine, ordinary, everyday decisions relating to the management of the platform and must be bound by those decisions.
If a DeFi is found to be an MIS the legal persons operating it could require registration and an Australian Financial Services Licence with the appropriate authorisations. If a DeFi is found to be operating an unregistered and unlicenced MIS in instances where registration and licensing is needed, the legal persons operating it could be in breach of sections 601ED and 911A of the Act, which could incur both a civil penalty and constitute a criminal offence. There are also risks of personal liability for Australian directors and representatives.
Importantly, the laws regarding crypto issuance and DeFis in Australia are largely untested. ASIC has broad powers to interpret, apply and enforce laws relating to DeFis and MIS. Thus, the connection between DeFis and the MIS regime could become clearer as more regulatory guidance becomes available in the near future.
In any event, whether a particular DeFi is an MIS will require a specific analysis of that application.